Chapter Six

US Fund Expenses and Fees

Mutual funds provide investors with many investment-related services, and for those services investors incur two primary types of expenses and fees: ongoing expenses and sales loads. Average expense ratios paid by mutual fund investors have fallen substantially over time. For example, on an asset-weighted basis, average expense ratios for equity mutual funds fell from 0.99 percent in 2000 to 0.59 percent in 2017, a 40 percent decline.

In this chapter

Trends in Mutual Fund Expenses

Mutual fund investors incur two primary types of expenses and fees: ongoing expenses and sales loads. Ongoing expenses cover portfolio management, fund administration, daily fund accounting and pricing, shareholder services (such as call centers and websites), distribution charges (known as 12b-1 fees), and other operating costs. These expenses are included in a fund’s expense ratio—the fund’s annual expenses expressed as a percentage of its assets. Because expenses are paid from fund assets, investors pay these expenses indirectly. Sales loads are paid at the time of share purchase (front-end loads), when shares are redeemed (back-end loads), or over time (level loads).

On an asset-weighted basis, average expense ratios* incurred by mutual fund investors have fallen substantially (Figure 6.1). In 2000, equity mutual fund investors incurred expense ratios of 0.99 percent, on average, or 99 cents for every $100 invested. By 2017, that average had fallen to 0.59 percent, a decline of 40 percent. Hybrid and bond mutual fund expense ratios also have declined. The average hybrid mutual fund expense ratio fell from 0.89 percent in 2000 to 0.70 percent in 2017, a reduction of 21 percent. In addition, the average bond mutual fund expense ratio fell from 0.76 percent in 2000 to 0.48 percent in 2017, a decline of 37 percent.

* In this chapter, unless otherwise noted, average expense ratios are calculated on an asset-weighted basis, which gives more weight to funds with greater assets. It reflects where investors are actually putting their assets, and thus, better reflects the actual expenses, fees, or performance experienced by investors than does a simple average (weighting each fund or share class equally). ICI’s fee research uses asset-weighted averages to summarize the expenses and fees that shareholders pay through funds. In this context, asset-weighted averages are preferable to simple averages, which would overstate the expenses and fees of funds in which investors hold few dollars. ICI weights the expense ratio of each fund’s share class by its year-end assets.

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Understanding the Decline in Mutual Fund Expense Ratios

Several factors help account for the steep drop in mutual fund expense ratios. First, expense ratios often vary inversely with fund assets. Some fund costs included in expense ratios—such as transfer agency fees, accounting and audit fees, and directors’ fees—are more or less fixed in dollar terms. This means that when a fund’s assets rise, these costs contribute less to a fund’s expense ratio. Thus, if the assets of a fixed sample of funds rise over time, the sample’s average expense ratio tends to fall over the same period (Figure 6.2).

1 Calculations are based on a fixed sample of share classes. Data exclude mutual funds available as investment choices in variable annuities, index mutual funds, and mutual funds that invest primarily in other mutual funds.

2 Expense ratios are measured as asset-weighted averages.

Sources: Investment Company Institute, Lipper, and Morningstar

Another factor contributing to the decline of the average expense ratios of long-term mutual funds is the shift toward no-load share classes (see No-Load Share Classes), particularly institutional no-load share classes, which tend to have below-average expense ratios. In part, this shift reflects a change in how investors pay for services from brokers and other financial professionals (see Mutual Fund Load Fees).

Mutual fund expense ratios also have fallen because of economies of scale and competition. Investor demand for mutual fund services has increased dramatically in recent years. From 1990 to 2017, the number of households owning mutual funds more than doubled—from 23.4 million to 56.2 million (see Figure 7.1). All else equal, this sharp increase in demand would tend to boost mutual fund expense ratios. Any such tendency, however, was mitigated by downward pressure on expense ratios—from competition among existing mutual fund sponsors, new mutual fund sponsors entering the industry, competition from products such as exchange-traded funds (ETFs) (see chapter 4 and here), and economies of scale resulting from the growth in fund assets.

Finally, shareholders tend to invest in mutual funds with below-average expense ratios (Figure 6.3). The simple average expense ratio of equity mutual funds (the average for all equity mutual funds offered for sale) was 1.25 percent in 2017. The asset-weighted average expense ratio for equity mutual funds (the average shareholders actually paid) was far lower at 0.59 percent.

Note: Data exclude mutual funds available as investment choices in variable annuities and mutual funds that invest primarily in other mutual funds.

Sources: Investment Company Institute, Lipper, and Morningstar

Another way to illustrate the tendency for investors to gravitate to lower-cost funds is to examine how they allocate their assets across funds according to their expense ratios. At year-end 2017, equity mutual funds with expense ratios in the lowest quartile held 77 percent of equity mutual funds’ total net assets, while those with expense ratios in the upper three quartiles held only 23 percent (Figure 6.4). This pattern holds for both actively managed and index equity mutual funds. Actively managed equity mutual funds with expense ratios in the lowest quartile held 72 percent of actively managed equity mutual funds’ total net assets at year-end 2017, and lower-cost index equity mutual funds held 78 percent of index equity mutual funds’ total net assets.

Note: Data exclude mutual funds available as investment choices in variable annuities and mutual funds that invest primarily in other mutual funds.

Sources: Investment Company Institute and Morningstar

Differences in Mutual Fund Expense Ratios

Like the prices of most goods and services, the expense ratios of individual mutual funds differ considerably across the array of available products. The expense ratios of individual funds depend on many factors, including investment objective (see here), fund assets (see here), and payments to financial intermediaries (see here).

Mutual Fund Investment Objective

Mutual fund expense ratios vary by investment objective (Figure 6.5). For example, bond and money market mutual funds tend to have lower expense ratios than equity mutual funds. Among equity mutual funds, expense ratios tend to be higher for funds that specialize in a given sector—such as healthcare or real estate—or those that invest in equities around the world, because such funds tend to cost more to manage. Even within a particular investment objective, mutual fund expense ratios can vary considerably. For example, 10 percent of equity mutual funds that focus on growth stocks have expense ratios of 0.70 percent or less, while the top 10 percent have expense ratios of 1.95 percent or more. This variation reflects, among other things, the fact that some growth funds focus more on small- or mid-cap stocks and others focus more on large-cap stocks. This is important because portfolios of small- and mid‑cap stocks tend to cost more to manage since information about these types of stocks is less readily available, and therefore portfolio managers spend more time doing research.

1 Data exclude mutual funds available as investment choices in variable annuities and mutual funds that invest primarily in other mutual funds.

2 Data include mutual funds that invest primarily in other mutual funds, but exclude mutual funds available as investment choices in variable annuities. Ninety-five percent of target date mutual funds invest primarily in other mutual funds.

Note: Each fund’s share class is weighted equally for the median, 10th, and 90th percentiles.

Sources: Investment Company Institute and Morningstar

Index Funds

An index fund generally seeks to replicate the return on a specified index. Under this approach, often referred to as passive management, portfolio managers buy and hold all, or a representative sample of, the securities in their target indexes. This approach to portfolio management is a primary reason that index funds—whether mutual funds or ETFs—tend to have below-average expense ratios. By contrast, under an active management approach, managers have more discretion to increase or reduce exposure to sectors or securities within their funds’ investment mandates. Active managers may also undertake significant research about stocks or bonds, market sectors, or geographic regions. This approach offers investors the chance to earn superior returns, or to meet other investment objectives such as limiting downside risk, managing volatility, under- or over-weighting various sectors, and altering asset allocations in response to market conditions. These characteristics tend to make active management more costly than management of an index fund.

Index Mutual Fund Expense Ratios

Growth in index mutual funds has contributed to the decline in asset-weighted average expense ratios of equity and bond mutual funds. From 2005 to 2017, index mutual fund total net assets grew significantly, from $619 billion to $3.4 trillion (Figure 6.6). Consequently, over the same period, index mutual funds’ share of long-term mutual fund total net assets more than doubled, from 9.0 percent in 2005 to 21.2 percent in 2017. Within index mutual funds, index equity mutual funds accounted for the lion’s share (81 percent) of index mutual fund total net assets in 2017.

Index mutual funds tend to have below-average expense ratios for several reasons. First, their approach to portfolio management—in which managers generally seek to replicate the return on a specified index by buying and holding all, or a representative sample of, the securities in their target indexes—lends itself to being less costly. This is because index funds’ portfolios tend not to change frequently, and therefore have low turnover rates.

Second, index mutual funds tend to have below-average expense ratios because of their investment focus. Total net assets of index equity mutual funds are concentrated more heavily in large-cap blend funds that target US large-cap indexes, such as the S&P 500. Total net assets of actively managed equity mutual funds, on the other hand, are more widely distributed across stocks of varying capitalization, international regions, or specialized business sectors. Managing portfolios of mid- or small-cap, international, or sector stocks is generally acknowledged to be more expensive than managing portfolios of US large-cap stocks.

Figure 6.6

Total Net Assets and Number of Index Mutual Funds Have Increased in Recent Years

Note: Data exclude mutual funds that invest primarily in other mutual funds. Components may not add to the total because of rounding.

Third, index mutual funds are larger on average than actively managed mutual funds, which, through economies of scale, helps reduce fund expense ratios. In 2017, the size of the average index equity mutual fund ($7.1 billion) was four times as large as the size of the average actively managed equity mutual fund ($1.8 billion).

Finally, index mutual fund investors who hire financial professionals might pay for that service out of pocket, rather than through the fund’s expense ratio (see Mutual Fund Load Fees on page 132). In contrast, actively managed mutual funds more commonly have share classes that bundle those costs into the expense ratio.

These reasons, among others, help explain why index mutual funds generally have lower expense ratios than actively managed mutual funds. It is important to note that both index and actively managed mutual funds have contributed to the decline in the average expense ratios of mutual funds (Figure 6.7). From 2000 to 2017, the average expense ratio of index equity mutual funds fell from 0.27 percent to 0.09 percent, while the average expense ratio for actively managed equity mutual funds fell from 1.06 percent to 0.78 percent. Over the same period, the average expense ratio of index bond mutual funds fell from 0.21 percent to 0.07 percent and the average expense ratio of actively managed bond mutual funds fell from 0.78 percent to 0.55 percent.

Note: Expense ratios are measured as asset-weighted averages. Data exclude mutual funds available as investment choices in variable annuities and mutual funds that invest primarily in other mutual funds.

Sources: Investment Company Institute, Lipper, and Morningstar

The downward trend in the average expense ratios of both index and actively managed mutual funds reflects, in part, investors’ increasing tendency to buy lower-cost funds. Investor demand for index mutual funds is disproportionately concentrated in funds with the lowest costs. This phenomenon is not unique to index mutual funds, however; the proportion of assets in the lowest-cost actively managed mutual funds is also high (Figure 6.4).

Index ETF Expense Ratios

The trends in ETFs over the past decade have influenced asset-weighted average expense ratios of index equity and index bond ETFs. ETF total net assets have grown rapidly in recent years, from $301 billion at year-end 2005 to $3.4 trillion at year-end 2017 (Figure 2.1). During this time, ETFs have become a significant market participant, with assets now accounting for about 15 percent of total net assets managed by investment companies at year-end 2017. ETFs are largely index-based and registered with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940. Actively managed ETFs and non–1940 Act ETFs represented only 3.3 percent of ETF total net assets at year-end 2017. Like index mutual funds, most of the total net assets in ETFs are in funds that focus on equities. Equity ETFs account for more than 80 percent of the total net assets of ETFs.

Part of the strong growth in ETFs is attributable to their distribution structure, in which the ETF generally charges an expense ratio that provides no compensation to financial professionals. Compensation to financial professionals for distribution or account servicing and maintenance is typically paid by the investor directly.*

* Some ETFs bundle distribution fees in the expense ratio to cover marketing and distribution expenses. These fees are usually small, typically ranging between 0.01 and 0.04 percent.

Financial professionals often provide programs that offer investors a suite of ETFs suited to their investment goals. In such cases, investors would typically pay financial professionals an asset-based fee in addition to the expense ratios of the ETFs in the suite of ETFs selected. Also, because ETFs are generally index funds, they typically have lower expense ratios.

Like mutual fund investors, ETF shareholders tend to invest in funds with below-average expense ratios (Figure 6.8). The simple average expense ratio of index equity ETFs (the average for all index equity ETFs offered for sale) was 0.50 percent in 2017. The asset-weighted average expense ratio for index equity ETFs (the average shareholders actually paid) was less than half of that, 0.21 percent. The same holds for index bond ETFs, with a simple average expense ratio of 0.29 percent in 2017 and an asset-weighted average expense ratio of 0.18 percent.

Figure 6.8

Expense Ratios Incurred by Index ETF Investors Have Declined in Recent Years

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Additionally, index ETF expense ratios differ based on their investment objectives (Figure 6.9). Among index bond ETFs, for example, expense ratios tend to be higher for ETFs that invest in either foreign or high-yield bonds because such securities are typically more costly to manage than, for example, Treasury bonds. Indeed, the asset-weighted average expense ratio for index high-yield bond ETFs was 0.46 percent in 2017, compared to the asset-weighted average expense ratio of 0.18 percent for index government bond ETFs. Even within specific investment objectives, expense ratios will vary among different index ETFs for a range of reasons. For example, expense ratios may differ because not all index ETFs in a given investment objective rely on the same index, and licensing fees that ETFs pay to index providers may vary.

Note: Each fund’s share class is weighted equally for the median, 10th, and 90th percentiles. Data exclude ETFs not registered under the Investment Company Act of 1940 and ETFs that invest primarily in other ETFs.

Sources: Investment Company Institute and Morningstar

Mutual Fund Fee Structures

Mutual funds often are categorized by the class of shares that fund sponsors offer, primarily load or no-load classes. Load classes generally serve investors who buy shares through financial professionals; no-load classes usually serve investors who buy shares without the assistance of a financial professional or who choose to compensate their financial professionals separately. Funds sold through financial professionals typically offer more than one share class in order to provide investors with alternative ways to pay for financial services.

12b-1 Fees

Since 1980, when the US Securities and Exchange Commission adopted Rule 12b-1 under the Investment Company Act of 1940, mutual funds and their shareholders have had the flexibility to compensate financial professionals and other financial intermediaries through asset-based fees. These distribution fees, known as 12b-1 fees, enable investors to pay indirectly for some or all of the services they receive from financial professionals (such as their broker) and other financial intermediaries (such as retirement plan recordkeepers and discount brokerage firms). Funds also use 12b-1 fees to a very limited extent to help defray advertising and marketing costs.

Load Share Classes

Load share classes include a sales load, a 12b-1 fee, or both. Sales loads and 12b-1 fees are used to compensate brokers and other financial professionals for their services.

Front-end load shares, which are predominantly Class A shares, were the traditional way investors compensated financial professionals for assistance. These shares generally charge a sales load—a percentage of the sales price or offering price—at the time of purchase. They also generally have a 12b-1 fee, often 0.25 percent (25 basis points). Front-end load shares are sometimes used in employer-sponsored retirement plans, but fund sponsors typically waive the sales load for purchases made through such retirement plans. Additionally, front-end load fees often decline as the size of an investor’s initial purchase rises (called breakpoint discounts), and many fund providers offer discounted load fees when an investor has total balances exceeding a given amount in that provider’s funds.

Back-end load shares, often called Class B shares, typically do not have a front-end load. Investors using back-end load shares pay for services provided by financial professionals through a combination of an annual 12b-1 fee and a contingent deferred sales load (CDSL). The CDSL is paid if fund shares are redeemed before a given number of years of ownership. Back-end load shares usually convert after a specified number of years to a share class with a lower 12b-1 fee (for example, Class A shares). The assets in back-end load shares have declined substantially in recent years.

Level load shares, which include Class C shares, generally do not have front-end loads. Investors in this share class compensate financial professionals with an annual 12b-1 fee (typically 1 percent) and a CDSL (also typically 1 percent) that shareholders pay if they sell their shares within a year of purchase.

No-Load Share Classes

No-load share classes have neither a front-end load nor a CDSL, and have a 12b-1 fee of 0.25 percent (25 basis points) or less. Originally, no-load share classes were sold directly by mutual fund sponsors to investors. Now, investors can purchase no-load funds through employer-sponsored retirement plans, discount brokerage firms, and bank trust departments, as well as directly from mutual fund sponsors. Some financial professionals who charge investors separately for their services, rather than through a load or 12b-1 fee, help investors select a portfolio of no-load funds.

Mutual Fund Load Fees

Many mutual fund investors engage an investment professional, such as a broker, an investment adviser, or a financial planner. Among households owning mutual fund shares outside employer-sponsored retirement plans, 79 percent own mutual fund shares through investment professionals (Figure 7.9). These professionals can provide many benefits to investors, such as helping them identify financial goals, analyzing an existing financial portfolio, determining an appropriate asset allocation, and (depending on the type of financial professional) providing investment advice or recommendations to help investors achieve their financial goals. The investment professional also may provide ongoing services, such as responding to investors’ inquiries or periodically reviewing and rebalancing their portfolios.

Over the past few decades, the way that fund shareholders compensate financial professionals has changed significantly, moving away from front-end loads toward asset-based fees. An important element in the changing distribution structure of mutual funds has been this shift toward asset-based fees, which are assessed as a percentage of the assets that the financial professional helps an investor manage. Increasingly, these fees compensate brokers and other financial professionals who sell mutual funds. An investor may pay an asset-based fee indirectly through a fund’s 12b-1 fee, which is included in the fund’s expense ratio, or directly (out of pocket) to the financial professional, in which case it is not included in the fund’s expense ratio.

In part because of the shift toward asset-based fees (either through the fund or out of pocket), the total net assets of front-end and back-end load share classes have declined in recent years, while those in no-load share classes have increased substantially. For example, over the past 10 years, front-end and back-end load share classes had $1.2 trillion in net outflows (Figure 6.10), and gross sales of back-end load share classes have dwindled almost to zero (Figure 6.11). As a result, the percentage of long-term mutual fund total net assets held in front-end and back-end load share classes fell by half, from 26 percent at year-end 2008 to 13 percent at year-end 2017 (Figure 6.12).

By contrast, no-load share classes have seen net inflows and rising total net assets over the past 10 years. No-load share classes—those with neither a front-end nor a back-end load fee and a 12b-1 fee of no more than 0.25 percent—have accumulated the bulk of the net inflows to long-term mutual funds over this period (Figure 6.10). At year-end 2008, no-load share classes accounted for 53 percent of long-term mutual fund total net assets, rising to 70 percent by year-end 2017 (Figure 6.12).

Some of the shift toward no-load share classes can be attributed to do-it-yourself investors. A larger factor, however, is the growth of sales through DC plans as well as sales of no-load share classes through sales channels that compensate financial professionals (for example, discount brokers, fee-based advisers, full-service brokerage platforms) with asset-based fees outside of funds.

7 “R” shares include assets in any share class that ICI designates as a “retirement share class.” These share classes are sold predominantly to employer-sponsored retirement plans. However, other share classes—including retail and institutional share classes—also contain investments made through 401(k) plans or IRAs.

(*) = inflow or outflow of less than $500 million

Note: Components may not add to the totals because of rounding. Data exclude mutual funds that invest primarily in other mutual funds.

7 “R” shares include assets in any share class that ICI designates as a “retirement share class.” These share classes are sold predominantly to employer-sponsored retirement plans. However, other share classes—including retail and institutional share classes—also contain investments made through 401(k) plans or IRAs.

(*) = gross sales of less than $500 million

Note: Components may not add to the totals because of rounding. Data exclude mutual funds that invest primarily in other mutual funds.

Sources: Investment Company Institute, Lipper, and Morningstar

Figure 6.12

Total Net Assets of Long-Term Mutual Funds Are Concentrated in No-Load Share Classes

7 “R” shares include assets in any share class that ICI designates as a “retirement share class.” These share classes are sold predominantly to employer-sponsored retirement plans. However, other share classes—including retail and institutional share classes—also contain investments made through 401(k) plans or IRAs.

(*) = total net assets of less than $500 million

Note: Components may not add to the totals because of rounding. Data exclude mutual funds that invest primarily in other mutual funds.

Sources: Investment Company Institute, Lipper, and Morningstar

Services and Expenses in 401(k) Plans

Over the past two and a half decades, mutual funds have become the primary vehicle for 401(k) plan investments, with the share of employer-sponsored 401(k) plan assets invested in mutual funds rising from 9 percent at year-end 1990 to 67 percent at year-end 2017.

Two competing economic pressures confront employers: the need to attract and retain quality workers with competitive compensation packages and the need to keep their products and services competitively priced. In deciding whether to offer 401(k) plans to their workers, employers must decide if the benefits of offering a plan (in attracting and retaining quality workers) outweigh the costs of providing the plan and plan services. These costs are both the contributions the employer may make to an employee’s 401(k) account and the costs associated with setting up and administering the 401(k) plan on an ongoing basis.

To provide and maintain 401(k) plans, regulations require employers to obtain a variety of administrative, participant-focused, regulatory, and compliance services. Employers offering 401(k) plans typically hire service providers to operate these plans, and these providers charge fees for their services.

As with any employee benefit, the employer generally determines how the costs of providing the benefit will be shared between the employer and employee. 401(k) plan fees can be paid directly by the plan sponsor (the employer), directly by the plan participant (the employee), indirectly by the participant through fees or other reductions in returns paid to the investment provider, or by some combination of these methods (Figure 6.13).

One key driver of 401(k) plan fees is plan size. A BrightScope/ICI study of 2015 data for more than 15,000 large 401(k) plans found that plans with more assets had lower mutual fund expense ratios than those with less assets. For example, the asset-weighted average expense ratio for domestic equity mutual funds held in large 401(k) plans in 2015 ranged from 0.81 percent in plans with between $1 and $10 million in plan assets to 0.36 percent in plans with more than $1 billion in plan assets. These results are consistent across different investment objectives.

Note: In selecting the service provider(s) and deciding the cost sharing for the 401(k) plan, the employer/plan sponsor will determine which combinations of these fee arrangements will be used in the plan.

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Sixty-seven percent of 401(k) assets at year-end 2017 were invested in mutual funds, mainly equity mutual funds (60 percent of 401(k) mutual fund assets or 40 percent of all 401(k) plan assets). 401(k) plan participants investing in mutual funds tend to invest in lower-cost funds and funds with below-average portfolio turnover. For example, at year-end 2016, 49 percent of 401(k) equity mutual fund assets were in funds that had average expense ratios of less than 0.50 percent, and another 41 percent had expense ratios between 0.50 and 1.00 percent (Figure 6.14). Taking into account both the funds offered in 401(k) plans and the distribution of assets in those funds, 401(k) plan participants who invested in equity mutual funds paid 0.48 percent on average in 2016, less than the asset-weighted average expense ratio of 0.63 percent for equity mutual funds industrywide. Similarly, equity mutual funds held in 401(k) accounts tend to have lower portfolio turnover in their portfolios. The asset-weighted average turnover rate of equity mutual funds held in 401(k) accounts was 28 percent in 2016, less than the industrywide asset-weighted average of 34 percent.